Wall Street's Worst-Kept Secret

If you own stocks, you should own small caps. OK, that's not really personal investment advice. It's Wall Street's worst-kept secret: Over the long haul, small-company stocks make you more money.

You're serious about this
You want an edge. So why make this difficult? History tells us that investors who make the most money over the long term buy and hold common stocks.

At least, they have since Ibbotson Associates started keeping track back in 1926 (and yes, I think it's still true). Investors looking to goose their returns even more own small caps, also according to Ibbotson.

The way I see it, we have a few choices. We can take a chance on a low-cost small-cap fund. We can buy a small-cap exchange-traded fund (ETF) -- I own a few myself. Or we can start building a small-cap portfolio of our own.

You're a Fool ... and so am I
Naturally, we favor the do-it-yourself approach. Well, sort of. You see, I have the occasional cup of joe with my friend Tom Gardner, co-founder of The Motley Fool -- a guy who made a career out of beating Wall Street to profits on small, well-run companies.

And you know what? I can admit that Tom and the team of analysts he hand-picked to manage his Motley Fool Hidden Gems newsletter service are building a portfolio of small caps I couldn't have found on my own. What's their secret?

I think it's that they focus more on value, while I tend to get wowed by story. For all of that, we do look for many of the same things in a great small company:

  • Solid management with significant stakes.
  • Great, sustainable businesses.
  • Dominant positions in niche markets.
  • Sterling balance sheets.
  • Strong free cash flow.

As hard as it is to imagine now, these traits led investors to John Morgridge and Cisco Systems (Nasdaq: CSCO  ) back in the day; even Jim Sinegal and Costco (Nasdaq: COST  ) . I don't have to tell you how those investments worked out.

Good work if you can get it
I know what you're thinking: Who wouldn't want to own stocks like those -- at least in their prime? And you're right. That's why it's so hard to beat the pros with familiar stocks like those now; if they're really all that, they're going to cost you.

But what are you going to do instead? Take a chance on some fly by-night outfit? Also a good point. But notice I said familiar stocks – not necessarily familiar companies. There's a subtle difference if you think about it.

To see what I mean, consider big retailers Target (NYSE: TGT  ) and Lowe's (NYSE: LOW  ) . They're both heavily owned by institutional investors now, but that wasn't always the case. I remember a time when both had strong regional and even national bricks-and-mortar footprints long before they were closely followed on Wall Street.

Need more proof?
Check out Fool Tim Hanson's list of the best-performing stocks of the past 10 years. You won't find a bunch of "widely helds" like Dell (Nasdaq: DELL  ) or Microsoft (Nasdaq: MSFT  ) on the list. Though don't be surprised if you recognize a company like juice drink-maker Hansen Natural (Nasdaq: HANS  ) from "real life" -- just as you probably recognized Target and Lowe's from the strip mall. 

Of course, that's your edge: You can find established, profitable companies with unknown stocks. Some you've heard of; some you may not have. Peter Lynch was a master at digging up these undiscovered gems. That's a big part of why he earned his Fidelity Magellan fundholders an average of nearly 30% a year.

Some more personal advice
If you agree that what I say makes sense, test the waters with a low-cost small-cap index fund like iShares S&P 600 Small-Cap Value Index (IJS), and then shift gradually into the stocks Tom Gardner's guys tell you about each month in his Motley Fool Hidden Gems newsletter.

Even better, check out the small-cap stocks the team is buying right now for its own real-money portfolio. At last count, these picks were outperforming the market by 2-to-1. Best of all, you can try the complete Hidden Gems service free.

You can even print out every back issue, if you like. And there's never any pressure to subscribe. I haven't seen a market better suited to small caps since 2003. I bought then, and I'm buying more now. I hope you'll consider doing likewise. To learn more about trying Hidden Gems for free, simply click here.

This article was originally published Jan. 7, 2005. It has been updated.

Paul Elliott owns shares of the iShares S&P Small-Cap 600 Growth Index and the iShares S&P Small-Cap 600 Value Index. Amazon.com is a Motley Fool Stock Advisor pick. Dell and Microsoft are Inside Value choices. Hansen Natural is a Rule Breakers selection. You can see the entire Hidden Gems scorecard with your free trial. The Motley Fool has a full disclosure policy.


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